Business Valuation 101

Feb 13, 2024Business Appraisals

If someone is going to buy your business – how will you determine a sale price and justify the sale price to the buyer?

When it comes to determining the value of a business, appraisers employ various methods, each designed to provide a different perspective on a company’s worth. These approaches can be categorized into three main categories: the asset approach, market approach, and income approach.

1. Asset Approach:

The asset approach focuses on evaluating a business based on the value of its underlying assets. This method is particularly useful when a business’s primary purpose is to hold and manage assets, such as real estate or investments. There are two main subcategories within the asset approach:

Book Value: This approach simply calculates the net value of a business’s assets after deducting liabilities. It provides a snapshot of a business’s financial health but may not reflect its true market value.

Adjusted Net Asset Value: This method considers the fair market value of assets and liabilities, providing a more accurate representation of the business’s worth.

2. Market Approach:

The market approach relies on comparing the subject business to similar businesses that have been sold recently. It is similar to the way real estate appraisals consider the prices of recently sold comparable properties. There are two primary techniques within the market approach:

Guideline Public Company Method: This method compares the subject business to publicly traded companies within the same industry, considering factors such as market multiples and stock prices.

Guideline Transaction Method: In this approach, the appraiser analyzes completed transactions of similar businesses to derive an understanding of their market value. I use this as a rule of thumb and never base 100% of the company value on market comps.

3. Income Approach:

The income approach values a business based on its expected future income or cash flow. This method is particularly useful for businesses with a history of generating income. The income approach includes two significant techniques:

Capitalization of Earnings: This method calculates the business’s value by dividing its expected earnings by the capitalization rate, which reflects the risk associated with the investment.

Discounted Cash Flow (DCF): DCF involves forecasting a business’s future cash flows and then discounting them to their present value. This method accounts for the time value of money and is widely regarded as a robust approach for businesses with predictable income streams.

Each of these three approaches has its strengths, and the choice of method depends on various factors, including the nature of the business, its industry, and the purpose of the appraisal. In practice, appraisers often use a combination of these methods to arrive at a comprehensive and accurate valuation.